We at Research Affiliates recently conducted our first virtual All Hands meeting after finding ourselves working from home in the wake of the COVID-19 crisis. As CIO, I responded to questions about our investment strategy. Katy Sherrerd, CEO, and Jeff Wilson, Head of Distribution, asked me to elaborate more broadly on my response to one of the questions submitted by email the day prior.
Question: It appears that a lot of value companies are being hit hard by coronavirus and tech companies (especially Amazon) are poised to actually do better through/after the pending recession since they are some of the only companies still hiring and with strong revenues. Does this shift our thinking about our investment strategy or do we feel that value will begin performing better soon?
I have great appreciation for this question. Both the preamble and the question itself raise important subjects. Let’s start by making the critical distinction between companies and their stock prices. Some companies will certainly grow faster than others and we readily observe which are likely to do so. But does that growth translate into relative outperformance?
Amazon, as was pointed out in the question, is growing rapidly. No doubt about it. Last year’s (2019) growth in sales was 20%. Growth in earnings per share (EPS) was 8%, not as fast as sales, but still an amazing growth rate for such an enormous company. With all of us now working from home with our servers on Amazon Web Services, Amazon is hiring as fast as it can and seems poised for continued rapid growth.
Does this unexpected and abrupt change in our workplace and environment shift our thinking about our investment strategy?
In a word, no. We at Research Affiliates remain convinced that proper fiduciary investing requires comparing the prices of companies’ stocks to estimates of their fundamental values. For my analysis, I use information available to me on March 23. Stock prices may have moved since then, but the point I am illustrating remains the same.
What about the price of AMZN? Its trailing 12-month EPS is $23. Mr. Market prices it at $1,900. That’s a price-to-earnings (P/E) ratio of 83.
But, what’s Amazon worth? We can roughly illustrate an estimate of value using a simple two-stage dividend discount model (DDM). The first stage extrapolates recent company growth for a decade into the future, and the second stage assumes a mature company that grows in line with the economy.